Draghi Outlook Seen Signaling Stimulus Odds: Euro Credit

By Jana Randow and Stefan Riecher -
Dec 5, 2013

Mario Draghi will probably hint at
the likelihood of more policy action as he unveils economic
forecasts for the euro area.

The European Central Bank president releases inflation and
growth projections today in the first rate-setting meeting since
a surprise November cut that a quarter of the Governing Council
opposed. Officials in Frankfurt will keep the benchmark interest
rate and the deposit rate unchanged this time round, according
to all economists in a Bloomberg News survey. The decision will
be announced at 1:45 p.m. in Frankfurt and Draghi will hold a
press conference that includes the forecasts 45 minutes later.

The predictions should add fuel to the debate over whether
the ECB has done enough to support the euro-region’s economic
revival or whether it needs to turn to measures such as a
negative deposit rate or the publication of minutes. While
inflation is well below the ECB’s target and the nascent
recovery is showing signs of fragility, the fact that official
interest rates are near zero means any further easing is likely
to be unorthodox.

“As conventional measures have been largely depleted, the
ECB is now confronted with policy choices that may have
significant side-effects on the functioning of markets, the
banking system and even on their reputation,” said Elwin de Groot, senior market economist at Rabobank Nederland in Utrecht.
“It seems fair to conclude that the council is divided on the
way forward.”

Weak Recovery

The Bank of England will keep its asset-purchase target at
375 billion pounds ($615 billion) and hold its benchmark rate at
0.5 percent today, according to separate surveys. That decision
is due at noon in London.

Since the ECB cut its key rate to a record low of 0.25
percent last month, data has shown that the euro-area recovery
came close to a halt in the third quarter as the French economy
unexpectedly shrank and Italy extended its longest postwar
recession. Lending has continued to contract and a survey of
purchasing managers showed manufacturing and services output in
the 17-nation region slowed for a second month in November.

“The recovery is weak,” said Anders Svendsen, an
economist at Nordea Bank Denmark A/S in Copenhagen. “We expect
very dovish signals from the ECB at this week’s monetary-policy
meeting, but no change in key rates. Risks are clearly skewed
toward another rate cut and the door is likely to be left wide
open to all non-conventional measures.”

Inflation Outlook

Euro-area inflation was 0.9 percent in November, compared
with the ECB’s target of just under 2 percent, and prices are
stagnating or declining on an annual basis in five of the 17
euro nations. That means economists and investors are awaiting
economic projections for 2015 to gauge the ECB’s need to act.

The institution currently predicts inflation will average
1.5 percent this year and 1.3 percent in 2014, with the economy
contracting 0.4 percent and growing 1 percent, respectively.

The new forecasts should give “both an indication of the
ECB’s current level of tolerance to low inflation and also help
guide market expectations as to how long the ECB’s accommodative
policy is likely to be in place,” said Nick Matthews, senior
economist at Nomura International Plc in London.

Matthews predicts the ECB’s staff will forecast inflation
and economic growth of 1.3 percent in 2015. Andrew Bosomworth,
managing director at Pacific Investment Management Co. in
Munich, said the forecasts will be for 2015 inflation of
slightly below 1.6 percent and growth of about 1.5 percent.

Further Options

ECB Governing Council member Ardo Hansson said in an
interview on Nov. 22 that policy makers haven’t “fully
exhausted” their room to cut interest rates yet and have a
variety of “other measures” at their disposal if needed.

One unprecedented option that officials have discussed is
charging banks for the excess liquidity they park at the ECB,
which would make it the first major central bank to venture into
negative deposit rates.

While Draghi said last month that the institution is
“technically ready” for a rate below zero, he also cautioned
that the consequences aren’t clear. One risk is that banks are
unable to pass the cost onto their depositors, squeezing their
profit margins and deterring them from lending to companies,
households or each other.

Market Disruption

Janet Yellen, the nominee for U.S. Federal Reserve
Chairman, said in testimony to the Senate Banking Committee in
Washington on Nov. 14 that lowering the deposit rate increases
the risk that money markets are disrupted. The Fed currently
pays 0.25 percent on excess reserves.

Bloomberg News reported on Nov. 20. that officials are
weighing a smaller-than-usual cut in the deposit rate to minus
0.1 percent to minimize any disturbance. ECB Vice President
Vitor Constancio said in an interview on Nov. 27 that the policy
would be invoked only in “quite extreme situations” and the
council is “not really near a decision.”

Constancio also said that banks’ access to funding has
improved and “is not the main cause of concern,” suggesting
that measures to increase liquidity such as new long-term loans
aren’t imminent. Banks have returned almost 40 percent of the 1
trillion euros ($1.4 trillion) in emergency cash they borrowed
for three years at the height of the financial crisis in 2011
and 2012.

Money Markets

Even so, risks remain. As banks adjust their balance sheets
at the end of the year, the rate on 1-month Eonia swaps, a
measure of interbank lending, has jumped to the highest level in
almost 1 1/2 years at 0.15 percent and now exceeds the rate for
6-month swaps. That signals banks are charging more for short-term funding, undermining the ECB’s easy-money policy.

A surge in market rates this year prompted Draghi in July
to introduce the ECB’s forward guidance, a pledge to keep
official interest rates at or below current levels for an
extended period.

While Draghi may not offer a more specific commitment
today, he may announce more transparency to come in the release
of details of the Governing Council’s deliberations. He said in
August that the ECB’s Executive Board will make a proposal to
the council “during this fall.”

That’s also a point of debate. Governors including
Estonia’s Hansson and Austria’s Ewald Nowotny have expressed
their concern that publishing minutes with individual votes
might expose policy makers to political pressure from their
national governments.

“The ECB’s job is far from done and more action is likely
in the coming months,” said Carsten Brzeski, senior economist
at ING Groep NV in Brussels. “But none of the possible steps
are without risk. The ECB will need to find the right balance
between being bold and reckless.”